How did some of the smartest investors, who had generated outsized returns for a long time with their skills, get caught flat-footed by the largest financial crisis the world had seen in several decades? The authors of The Global Economic System explain.

This chapter is from the book

The global economic crisis of 2008 and 2009 caught many of the most astute investors in the financial markets by surprise. While only 49 hedge funds failed during all of 2007, 344 hedge funds failed during just the third quarter of 2008, and another 778 hedge funds failed during the fourth quarter of 2008. Similarly, while only 3 banks failed in 2007, 25 banks failed in 2008, and 140 failed in 2009. Endowment funds, the financial backbone of private universities, which had posted stellar investment results throughout the 2000s, had an investment return of -19% during fiscal 2009. The four biggest funds, with widely acclaimed investment managers, posted returns of -27% (Harvard), -25% (Yale), -27% (Stanford), and -23% (Princeton). Private equity funds lost 15% in 2008.

As a description of the money management industry during 2008-2009, one of the most widely circulated quotes was provided by the "sage of Omaha," Warren Buffet, who once said "you only find out who is swimming naked when the tide goes out."1 So how did some of the smartest investors, who had generated outsized returns for a long time with their skills, get caught flat-footed by the largest financial crisis the world had seen in several decades? Were they all in reality "swimming naked"?

1.1 Peso Problem

In his famous quote, Buffet is referring to a phenomenon known in academic circles as a "peso problem"—a term commonly attributed to Nobel laureate Milton Friedman for comments he made about trading in the Mexican peso in the early 1970s. At the time, the exchange rate between the U.S. dollar and the Mexican peso was fixed at that time as both countries were following the Bretton Woods Agreements. However, looking at interest rates on government bonds in Mexico and comparing them to interest rates on similar-maturity government bonds in the United States, one found that the interest rates in Mexico were far higher—despite the fixed exchange rate. This posed a bit of a puzzle. Investors could borrow U.S. dollars and pay a low interest rate, convert these dollars into pesos, and then invest the pesos into Mexican government bonds and earn a high interest rate. When the Mexican bonds matured, the investor could simply convert the peso principal and interest back into dollars at the same exchange rate that he did the initial conversion. He could then pay back the dollar borrowings and he would be left with a profit, equal to the interest rate differential between Mexican and U.S. interest rates times the principal amount borrowed. In modern terms, this is known as a carry trade. However because the exchange rate was fixed, there was no risk in this carry trade. Therefore the profit from the carry trade could be earned with no risk—a condition that financial economists refer to as an arbitrage, or free money. How could this prevail in the financial markets? In trying to explain this phenomenon, Friedman noted that perhaps the interest rate differential between the two countries reflected a hidden risk factor that no one could observe in financial market data because the downside effects of this risk had not occurred yet. He speculated that this risk factor was the possibility of a devaluation of the Mexican peso. And sure enough, in August 1976 the peso was allowed to float against the dollar, and the peso promptly fell 46%.